Exactly the same procedures are adopted for leasehold land and buildings as applied to freehold land and buildings except in the issue of depreciation. There is no split between land and buildings when it is leasehold. In this case the land and buildings are amortised over the life of the lease even though the buildings may have an economic life longer than that of the lease. The argument for this is that the landlord after the end of the lease can comfortably ask you to take your building and go and he wants his land back. The term used is amortisation not depreciation.
The authoritative document is IAS 17 Leases
The appropriate method of depreciation or amortisation to use in the case of freehold buildings and leasehold property is straight-line. This is because there is no objective basis of determining whether one year has benefited more from the use of the land and building than any other year.
The main problem in the audit of leased assets in the books of the user of the asset is to ensure that a proper split has been made between assets under an operating lease and assets under a finance lease. It should be recognized that there may be a high risk in this area due to the client preferring the asset to be recognized as an operating lease as this will keep the asset and the liability off the balance sheet.
The definition of a finance lease (one under which substantially all risks and regards of ownership are transferred to the lessee) is not easy to apply in practice.
The calculations used to determine whether a lease is a finance lease can be quite complex and thus the auditor must ensure that he understands the principals behind the calculations and that the assumptions used (e.g. the implicit rate of interest) are reasonable. Having understood the principles, a sample of the calculations need to be checked for all leases i.e. including those which the client has designated as operating leases.
For the leases which have been classified as finance leases, a sample needs to be checked for the following matters:
Check method used to split interest and capital
Check the method is correctly applied to lease payments
Check depreciation is based on the shorter of the lease term and the useful life of the asset to the lessee.
In addition ‘normal’ audit tests apply to verification of the asset as for any other non current asset.
If the lease has been classified as an operating lease, then a check is required of the manner in which the rentals have been charged to the income statement. A check should also be made on the physical existence of the asset if at the time of the audit the lease is still in existence.
Finally regard should be made to the possibility of assets being held under leases also being shown in normal non current assets in the balance sheet. This is particularly relevant to operating leases where the existence of a physical asset at the balance sheet date may be used to support the inclusion of the asset in the non current asset account.